Don’t Be Fooled By Your Tax Return

Look at this 1040.  Notice anything missing? 


That’s okay. Let’s throw some numbers in there and see if anything now looks odd.

There are a bunch of things going on here.  Notice Line 2B. This couple has $22,871 of Taxable Interest. On  Line 3B they have $8,362 in Dividends. Also notice they have $0 on Lines 1, 4 and 5;  No wages, no IRA distributions and no Social Security benefits. 

Finally, you’ll notice on Line 7 their Adjusted Gross Income(AGI) is $96,869. Subtract out the Standard Deduction on Line 8 and you’ll have…WAIT!!!!  WHAT??? “Did you say their AGI is $96,896???”

“Yes I did say that.”

“HOW???  They only have around $30,000 in Taxable Interest and Dividend Income!!  Obviously, you’re wrong, Josh, as there is no other income on the 1040. Gotcha!”

Where Are The Capital Gains?

But I’m not wrong.  And this, my friends, is why you need to understand how your income is generated.   Remember, the 1040 is just the bottom line, the end result if you will, of how your income derived. 

Here’s a look at Schedule 1 for critical information regarding this taxpayer.

WHOA! Where’s this coming from?  

Well, these are the capital gains this taxpayer has generated.  Schedule D shows us the breakdown:

What you can see here is $65,000 in total Capital Gains, of which $59,000 is Long Term and $6,000 Short.

Your 1040 Isn’t All There Is!

That’s a lot of money, no? But if you only looked at the first page of the 1040 you would have missed all of this. There is no way you could have made a valid tax planning strategy without this critical piece of information.

After all, look at line 15 of the 1040 from above. This taxpayer paid all of $369 in taxes on GROSS INCOME of nearly $100,000!  Now that…is making good use of the tax code. But did they do this by luck, or by strategy?

Where Does Social Security Fit In?

Now, let’s say they begin receiving $45,000 in Social Security benefits. 

A couple points of interest here.

Notice Line 10.  Taxable income is $80,251.  Now go back to the previous 1040, BEFORE Social Security kicked in…

Line 10 shows taxable income of $69,869.  

But, with Social Security added, TOTAL INCOME increased by $45,000 yet TAXABLE INCOME only increased by around $10,000.

With me so far?

But, and this is HUGE, the Total Tax, Line 15, went up 12 times from $369 to $4,538!

Now, to be clear, this taxpayer is paying an additional $4,000 tax on an increase in income of $45,000.  That is an effective tax of only 9% on the additional income, even though they are actually in a 12% tax bracket. And when you factor in their paying $4,500 tax on a total GROSS income of nearly $115,000 their effective tax rate is 4%. This is due to the favorable treatment of Social Security and Capital Gains.  Not too shabby if you ask me. 

But it could have been so much better if they just paid attention.  Watch this:

This is what you want to see.  No taxes due at all! Why? For two reasons.

  1.  There are NO CAPITAL GAINS. 
    1. They are using the SPECIFIC IDENTIFICATION METHOD in which to identify shares to sell that are trading at cost basis or even below. 
    2. For instance, five years ago you bought 100 shares of XYZ stock for $35.  Two years ago you bought more, but this time the price was $50. The stock is trading at $45 right now. You SPECIFICALLY IDENTIFY the shares from 2 years ago to sell.  Meaning not only do you pay no capital gains tax but you also have a loss.
      1. Here is a Vanguard article talking about this.
  2.  There is no Social Security income.


Specific Identification is SOOO Valuable

Right now this taxpayer is living off selling shares at a loss or at cost and dividends and interest. As such, taxable income keeps them below the 22% bracket and thus they pay no tax on qualified dividends.  Their taxable interest and ordinary dividends are eaten up by the standard deduction, meaning they pay no tax on those either. Again…not too shabby, eh?

Let’s add back in Social Security:

Here we have an additional income of $45,360 in Social Security and yet a total tax burden of only $1,194.

Notice on Line 5b, only $14,818 of their total Social Security benefit is taxable.  And even this is unacceptable. Just some basic Asset Location strategies would reduce the income on Lines 2 and 3 which is what is making some of their Social Security taxable. 

Great Work, Taxpayers!

But, for now, let’s just pause and admire the great tax work these taxpayers have created. Over $100k income and yet paying only $1,194 in total tax.  Oh man, it’s a thing of beauty!

Oh, wait, am I hearing some naysayers in the peanut gallery? 

“What’s that? I can’t hear you. You need to yell louder.”  

“Oh, you are screaming that I’m mis-leading people because specific identification doesn’t eliminate capital gains tax only defers them?”  

You of little faith. If you use specific identification to sell your high basis, low gain shares and are left with only low basis high gain shares, what do you do next?

Do you sell those taxable shares? Not if you can avoid it. You leave those shares, with the gains, to your heirs via your Will.  Because upon their inheriting those shares your heirs receive the step-up basis, meaning their cost basis is what the date of death valuations of those shares were; i.e., they pay NO capital gains tax!

The tax code is a beautiful thing once you see it for what it is, a puzzle that must be solved. 

But if you aren’t paying attention, well you will be fooled and thus pay more tax.  Hmmm…could that be by design?

What do you think?  ☝

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